What would Brexit mean for the investment climate in the financial sector?

With just six weeks left to go, the battle over the UK’s continued membership of the European Union is rising in volume and intensity. A key issue for investors in UK-traded financial services products and markets is undoubtedly what effects the decision made on June 23 will have on the climate for purchasing or retaining bonds, equities or other assets linked to either the performance of sterling or the stock market. Ultimately these are reflections on the underlying health of the UK economy itself, and the likely economic temperature if the UK stays within or leaves the Single Market, both in the short term and medium-to-long term.

From the Leave side, recent analysis by Economists for Brexit has pointed to increased trade, deregulation, and growth from departing the EU, and trading more with other countries via the WTO rules. Their modelling purports to show a boost to GDP growth of 2% and 1.5% higher real disposable wages by 2020. The alternatives to EU membership being considered by the Leave campaign have been reduced in the last few weeks – their vision is of a UK leaving, but still having trading access to, the Single Market. It appears therefore that they have ruled out, for reasons of sovereignty and control over immigration policy, options such as the Norwegian membership of the European Economic Area (EEA) which brings with it Single Market entry for most purposes but no influence over Market rules, and the Swiss-style bilateral trade agreement providing access to the Single Market for most but not all purposes, but involving contributing to the EU budget, and accepting free movement of persons in addition. Their model presupposes that a lower regulatory burden on exiting the EU would be the equivalent of reducing national insurance contributions by 2%, and permitting lower tariffs. It has been widely noted that neither contention rests upon a strong evidential basis.

Alternatives to EU membership the Leave Campaign have left to advocate are therefore threefold – a free trade agreement, akin to that Canada took 7 years to negotiate with the EU, a Turkish-style customs union with the EU allowing quota and tariff free market access for most goods (other than raw agricultural produce) but not services, or trading with the Single Market under the World Trade Organisation rules. But with 45% of foreign direct investment to the UK going into the financial services sector, there are major questions about the degree of (if any) access to the Single Market for finance on exit, given that leaving the EU means abandoning the Single Rulebook, passporting of financial services entities, and the role of the EU institutions as the enforcers of Single Market-wide competition rules.

Bolstering the economic case for the Remain campaign have been two weighty interventions by the National Institute for Economic and Social Research (NIESR), and by the Bank of England in its quarterly Inflation Report. The NIESR study modelled the effects of the UK leaving the EU on growth and on wages, but without considering changes in migration policies, ie. whether net migration would remain at current levels or decrease as some Leave campaigners have expressed support for. Overall they conclude that UK exit from the EU would produce a depreciation of sterling’s value by around a fifth, rising prices for imports as a result, together with lower GDP growth and wages. It finds that if a free-trade agreement equivalent to CETA could be negotiated, that would lower UK GDP by 2.1% by 2020 on the central forecast, and wages by 2.6% in real terms. By 2030, the effect on GDP remains constant, ie. 2.1% lower than it would be with continued EU membership, and real wages 3.4% lower. If no such free trade agreement were in place, and the UK traded with the EU under WTO rules only, GDP would be 2.9% lower in 2020 than if the UK were an EU member state on the central forecast, and real wages 4.2% lower. By 2030, GDP would be 3.2% lower, and wages 5.5% lower in real terms. This is based upon a short-term shock to growth and investment after a Leave vote, with sterling likely to depreciate by a fifth, risk premia rising, making conditions for investment worse. With the UK’s current account deficit currently at 7% of GDP, depending on the kindness of overseas investors to continue funding this may be a gamble too far. Furthermore, departing the Single Market would also mean as Angus Armstrong concludes in the NIESR review that the UK no longer has access to the EU’s financial architecture, damaging financial stability in the process, with the real risk of capital flight.

The Bank of England’s conclusions in the May Inflation Report were unambiguous. Uncertainty caused by the Referendum was one of the causes of lower growth in the two quarters running up to the vote, and would likely result in lower economic demand in the economy if Leave won, alongside increased unemployment, and higher costs of raising finance from capital markets as risk premia rise, contributing to further corporate bond, equities and currency depreciation and falling prices for assets such as houses. The Bank also feared increases in the costs of bank funding, hurting consumers and businesses alike. Its modelling analysis shows that the risk of lower economic demand would more than outweigh any boost to exports through lower sterling exchange rates.

The British people make this most crucial of decisions in six weeks time. Financial and economic issues will be one consideration, questions of identity and sovereignty another. The weight of evidence is mounting however, that financial stability and a strong investment climate are critical to our economic security. Both campaigns have to demonstrate that their competing visions of the UK’s future rest on solid foundations.